Money printing sends all correlations to 1

It is really incredible that tens or even hundreds of thousands of dollars were spent by very well educated people on something that yielded not even a hint of a solid conclusion.

Reasons given by these professional economists and investors for the rise in correlation between all asset classes range from indexation, to ETF’s, globalisation and interconnectedness, to financial market crises.

Yet the most crucial stone of all is left unturned – looking at the value of the money that all these asset classes are being priced in.  When any currency loses value at a rapid rate, everything priced in it goes up at the same time.  It is really as simple as that.

What this does show is how poorly educated the so-called educated are on the subject of monetary economics.

Does this not make it that much clearer why the collapse of this fiat currency fractional reserve banking monetary regime is upon us?

As we mentioned back in June ‘10, in Explaining Rand strength 7 months later:

The rise and rise of correlation

By Anousha Sakoui and Izabella Kaminska

Published: October 6 2010 19:53 | Last updated: October 6 2010 20:17

Additional reporting by Richard Milne

“What we are saying to portfolio managers is ‘trust your instinct, rotate your portfolios less, and step back from the screen’,” says Soc Gen’s Charles de Boissezon. “If they stick to their strong fundamental views, and let go of the daily moves that create stress, they will find they are making returns from stock picking.”

From New York to Hong Kong, investors, dealers, analysts and academics are puzzled. For months, they have been struggling to explain an investment phenomenon that has defined this year’s sharp swings in financial markets. Now they may have an answer.

Like fish swimming in shoals, shares in the world’s largest companies have see-sawn in lockstep as investors have bought heavily only to head for the exits later. This indiscriminate buying and selling, also called “risk-on, risk-off” trading, has characterised the sharp swings in equity markets during the summer sell-off and later rally that has this week sent Wall Street to near five-month highs.

In theory, that should be good for stock-pickers: the higher the level of dispersion is, the bigger the differences in the performance of individual shares.

For investors, this trend has been one of the great challenges they have had to contend with in trying to generate returns in 2010. According to strategists, correlation, the extent to which assets, even those in different markets, move in tandem with one another, rose to a record during the summer.

The implications could be important for investors. “It isn’t just a problem for traders looking to make rhyme or reason out of market moves,” says Nicholas Colas, ConvergEx Group chief market strategist. “Rather it is a deeply corrosive issue that diminishes the value of investing altogether.”

Some commentators and so-called “value” investors, who seek out undervalued stocks, have gone as far as to declare stock-picking dead. As one US fund manager says: “We spend all this time picking stocks and then everything rises and falls at the same time. It is a nightmare.”

Most active fund managers add so-called “alpha”, or risk-adjusted returns, by focusing on earnings fundamentals and relative valuations. But rising correlation means that their work has gone unrewarded – stock moves have tended to be driven by sentiment about the direction of the global economy and little else.

“Correlation is a massive problem at the moment,” says Keith Skeoch, chief executive of Standard Life Investments “The markets are telling you ‘we are still swinging between two very fat tails of long-run returns: either going down like a stone or up like a rocket’.”

Now a paper published by the National Bureau of Economic Research in the US has shed light on the phenomenon. In the paper, Jeffrey Wurgler, finance professor at New York University, reveals how the impact of the simple inclusion of stocks in indices markedly affects their performance so that they move in tandem with other index members irrespective of differences in their earnings or relative valuations.

Mr Wurgler’s findings support theories that the growing popularity of index-linked investing, measured in the trillions of dollars, and the growth of “high-frequency trading”, which allows traders to buy and sell shares and derivatives in fractions of a second, may in part be responsible for increased correlation.

August proved to be one of the best months for some active investors. “We were all on holiday so did nothing to the portfolio – and hey presto! It was our best month this year,” he says.

Increasingly, analysts have pointed to the potential influence of indexation and popularity of index-based products, in particular futures and exchange-traded funds, ETFs, as a cause of increased correlation in recent years.

The creation and redemption of ETFs – a near $1,000bn market – leads to the buying and selling respectively of all the constituents of the indices tracked by the funds. This means that stock prices move more closely together.

All in all, Mr Wurgler estimates $8000bn of countable index-linked products.

Mr Wurgler has found that, on average, the share prices of stocks added to the S&P 500 between 1990 and 2005 have increased almost 9 per cent around the time of their inclusion in the index, with the effect rising over time as index fund assets have grown. Stocks deleted from the index have tumbled by even more.

Moreover, says Mr Wurgler, when a new company joins the S&P 500, the pattern of returns on that stock change “magically and quickly”. “It begins to move more closely with its 499 new neighbours and less closely with the rest of the market. It is as if it has joined a new school of fish,” he says. These “co-movement” patterns are where the real economic impact starts, he says.

Index members can also drift away from the rest of the market. This is because index-product users tend to pursue different strategies from those employed by more active investors. They are less interested in keeping close track of the relative valuations of index and non-index shares. By contrast, so-called arbitrageurs, such as high-frequency traders, seek out profit from the differences between index derivatives and the underlying stock.

True, Mr Wurgler’s is not the first study to highlight the distorting effects of index inclusion on stock prices. But, as he concludes, “the evidence is that stock prices are increasingly a function not just of fundamentals but also of the happenstance of index membership.”

He says this can drive bubbles and crashes as well a confused risk-return relationship as high-risk stocks have, on average, delivered lower returns than low-risk stocks in US markets and those around the world.

Others, however, dispute his findings. Analysts at Société Générale, for example, have studied correlation in European stock markets and found evidence to the contrary. They suggest that if ETFs or indexation were such an important driver of correlation, then correlation should be rising faster in a more popular ETF market such as the Euro Stoxx 50 than, say, on a less index-tracked market like the Stoxx Europe 600. In fact, correlation has been rising at a similar rate on both.

Some analysts believe that the reasons for assets prices moving more in tandem could be much simpler. One says the increased globalisation of financial markets and interconnectedness of different economies could be a factor. Also, correlation has historically tended to increase during crises.

One thing investors can do is to try to position themselves for a breakdown of correlation. Moreover opportunities for a return to stock picking may already have started to emerge, as some analysts point to levels of correlation retreating from summer highs.

The SocGen analysts believe that price dispersion, the extent to which the performances of stocks within a sector diverge, has not fallen, despite rising correlation.

n theory, that should be good for stock-pickers: the higher the level of dispersion is, the bigger the differences in the performance of individual shares.“What we are saying to portfolio managers is ‘trust your instinct, rotate your portfolios less, and step back from the screen’,” says Soc Gen’s Charles de Boissezon. “If they stick to their strong fundamental views, and let go of the daily moves that create stress, they will find they are making returns from stock picking.”

Additional reporting by Richard Milne